MONETARY, FISCAL AND INCOMES POLICY FOR STABILISATION

An economy may experience fluctuations in economic activity and may result in booms and
depressions which are very harmful to the economy and society. The classical economists believed
that an automatic mechanism works to restore stability in the economy; recession would cure itself
and inflation will be automatically controlled. However, there are evidences that no such automatic
mechanism works to bring stability in the economy. The two important tools of macroeconomic
policy for stabilization are fiscal policy and monetary policy. In addition incomes policy is also used
to stabilize the economy during times of instability. There are diverse opinion regarding the
effectiveness of alternative policies among economists for bringing stability and according to Keynes,
monetary policy was ineffective to lift the economy out of depression and he believed that fiscal
policy is more effective in bringing stability in the economy. In addition to the monetary and fiscal
policies, incomes policies are also used by economists to stabilize the economy.
Goals of Macroeconomic Policy
The three important objectives of macroeconomic policy are Economic Stability at a high
level of output and employment, Price Stability and Economic growth. We will briefly examine the
role of Monetary, Fiscal and Incomes policy for stabilizing the economy.
Meaning of Monetary Policy
Monetary policy is an important instrument to achieve the objectives of macroeconomic
policy. The monetary policy is formulated and implemented by the Central Bank of a country. In
some countries such as India the Central Bank (the Reserve Bank is the Central Bank of India) works
on behalf of the Government and acts according to its directions and broad guidelines of the
government. Howeve, in some countries such as the USA the Central Bank (i.e., Federal Reserve
Bank System) enjoys an independent status and pursues its independent policy.
Monetary policy is concerned with changing the supply of money stock and rate of interest for
the purpose of stabilizing the economy at full-employment or potential output level by influencing the
level of aggregate demand. More specifically, at times of recession, monetary policy involves the
adoption of some monetary tools which tend the increase the money supply and lower interest rates
so as to stimulate aggregate demand in the economy. On the other hand, at times of inflation,
monetary policy seeks to contract the aggregate spending by tightening the money supply or raising
the rate of interest. As stated above the broad objectives of monetary policy are to achieve full-
employment level of output, to ensure price stability and to promote economic growth of the
economy. It may however be noted that in a developing country such as India, in addition to
achieving equilibrium at full employment or potential output level, monetary policy has also to
promote and encourage economic growth both in the industrial and agricultural sectors of the
economy.
Objectives of Monetary Policy
The three important objectives of monetary policy are:
To ensure economic stability at full-employment or potential level of
output; To achieve price stability by controlling inflation and deflation; and
3. To promote and encourage economic growth in the economy.
In line with the above goals of monetary policy, growth with price stability is the goal of monetary
policy of the Reserve Bank of India. The role of monetary policy in achieving economic stability at a
higher level of output and employment is discussed below.

Instruments of Monetary Policy

 There are four major tools or instruments of monetary policy which can be used to achieve
economic and price stability by influencing aggregate demand or spending in the economy. They are:
Open market operations;
Changing the bank rate;
3. Changing the cash reserve ratio; and
4. Undertaking selective credit controls.
We shall explain how these various tools can be used for formulating a proper monetary
policy to influence levels of aggregate output, employment and prices in the economy. In times of
recession or depression, expansionary monetary policy (easy money policy) is adopted which raises
aggregate demand and thus stimulates the economy. On the other hand, in times of inflation and
excessive expansion, contractionary monetary policy (tight money policy) is adopted to control
inflation and achieve price stability through reducing aggregate demand in the economy. We discuss
below both these policies.
Monetary Policy to Control Depression (Recession)
When the economy is experiencing recession (involuntary unemployment), which is due to a
fall in aggregate demand, the central bank intervenes to cure such a situation. Central bank (Monetary
Authority) will expand the money supply in the economy to lower the rate of interest with a view to
increase the aggregate demand to stimulate the economy. The following three monetary policy
measures are adopted as a part of an expansionary monetary policy to cure recession and to establish
the equilibrium of national income at full employment level of output.
1. The central bank undertakes open market operations and buys securities in the open market.
Buying of securities by the central bank, from the public and from commercial banks will lead
to the increase in reserves of the commercial banks and amount of currency with the general
public. With greater reserves, commercial banks can issue more credit to the investors and
businessmen for undertaking more investment. More private investment will cause aggregate
demand curve to shift upward. Thus buying of securities will have an expansionary effect on
output and employment in the economy and the depression can be avoided.
2. The Central Bank may lower the bank rate (Discount rate), which is the rate of interest charged by
the central bank of a country on its loans to commercial banks. At a lower bank rate, the
commercial banks will be induced to borrow more from the central bank and will be able to
issue more credit at the lower rate of interest to businessmen and investors. This will not only
make credit cheaper but also increase the availability of credit or money supply in the
economy. The expansion in credit or money supply will increase the investment demand
which will tend to raise aggregate output and income and will avoid depression.
Thirdly, the central bank may reduce the Cash Reserve Ratio (CRR) to be kept by the commercial
banks. In countries like India, this is a more effective and direct way of expanding credit and
increasing money supply in the economy by the central bank. With lower reserve
requirements, a large amount of funds is released for providing loans to businessmen and
 investors. As a result, credit expands and investment increases in the economy which has an
expansionary effect on output and employment.

Similar to the Cash Reserve Ratio (CRR), in India there is another monetary instrument, namely,
Statutory Liquidity Ratio (SLR) used by the Reserve Bank to change the lending capacity and
therefore credit availability in the economy. According to the Statutory Liquidity Ratio, in
addition to the Cash Reserve Ratio (CRR), banks have to keep a certain minimum proportion
of their deposits in the form of some specified liquid assets such as Government securities. To
increase the lendable resources of the banks, Reserve Bank can lower this Statutory Liquidity
Ratio (SLR). Thus, when Reserve Bank of India lowers statutory liquidity Ratio (SLR), the
credit availability for the private sector will increase.
It may be noted that the use of all the above tools of monetary policy leads to an increase in
reserves or liquid resources with the banks. Since reserves are the basis on which banks expand their
credit by lending, the increase in reserves raises the money supply in the economy. Thus, appropriate
monetary policy at times of recession or depression can increase the availability of credit and also
lower the cost of credit. This leads to more private investment spending which has an expansionary
effect on the economy. From the above analysis, it is clear that monetary policy can play an important
role in stimulating the economy and ensuring stability at full employment level. But it is worth
mentioning that there are several weak links in the full chain of increase in money supply achieving a
significant expansion in economic activity. Keynes was of the view that monetary policy is not an
effective instrument in bringing about revival of the economy from the depressed state. In fact, he
laid stress on the adoption of fiscal policy to overcome depression.

Fiscal Policy for Economic Stabilisation

The economy does not always work smoothly and there are fluctuations in the level of
economic activity. At times the economy finds itself in the grip of recession when levels of national
income, output and employment are far below their full potential levels. During recession, there is a
lot of idle or unutilized productive capacity. As a result, unemployment of labour increases along
with the existence of excess capital stock. At other times, inflation (i.e. rising prices) occurs in the
economy. Thus, in a free market economy there is a lot of economic instability. The classical
economists believed that an automatic mechanism works to restore stability in the economy;
recession would cure itself and inflation will be automatically controlled. However, the empirical
evidence during the 1930s when severe depression took place in the Western capitalist economies and
also the evidence of post Second World II period amply shows that no such automatic mechanism
works to bring about stability in the economy. That is why Keynes argued for intervention by the
Government to cure depression and inflation by adopting appropriate tools of macroeconomic policy.
The two important tools of macroeconomic policy are fiscal policy and monetary policy. Here, we
shall explain the role of fiscal policy for stabilizing the economy. According to Keynes, monetary
policy was ineffective to lift the economy out of depression and hence, he emphasized the role of
fiscal policy as an effective tool to lift the economy.
Meaning of Fiscal Policy
Fisc means treasury and hence fiscal policy is the use of taxation, public expenditure and
public borrowing either for economic development or for economic stability. In the words of Arthur
Smithies, fiscal policy is a policy under which the government uses its expenditure and revenue
programmes to produce desirable effects and to avoid undesirable effects on the national income,
production and employment.
Objectives of Fiscal Policy
The three important goals or objectives of fiscal policy are:
Economic stability at a high level of output and employment, Price stability and Economic Growth
We shall discuss the role of fiscal policy in achieving economic stability at full employment level
and in controlling inflation and deflation and thus attaining price stability.
Instruments of Fiscal Policy
The major instruments of Fiscal policy are Taxation, Public Expenditure and Public
borrowing. The government (fiscal authority) uses these instruments for economic stability or for
economic development. Some times, the term budgetary policy is also used to represent fiscal policy.
Fiscal Policy for Stabilisation
Fiscal policy is an important instrument to stabilize the economy, that is, to overcome
recession and control inflation in the economy. Fiscal policy is the policy of the government in which
government uses tax, expenditure and borrowing policies to stabilize the economy. Thus, by fiscal
policy, we mean deliberate change in the government expenditure and taxes to influence the level of
national output and prices. Fiscal policy generally aims at managing aggregate demand for goods and
services. At the time of recession the Government increases its expenditure and reduces
tax rates. On the other hand, to control inflation the government reduces its expenditure and
raises taxes. In other words, to cure recession expansionary fiscal policy and to control inflation
contractionary fiscal policy is adopted. It is worth mentioning that fiscal policy aims at changing
aggregate demand by suitable changes in government spending and taxes. Thus, fiscal policy is
mainly a policy of demand management. It should be further noted that when the government
adopts expansionary fiscal policy to cure recession, it raises its expenditure without raising taxes
or cuts down taxes without changing expenditure or increases expenditure and cuts down taxes
as well. With the adoption of expansionary fiscal policy, Government will have deficit in its
budget. Thus, expansionary fiscal policy to cure recession and unemployment will involve a
deficit budget. On the other hand, to control inflation, Government reduces its expenditure and
increases taxes and will have a surplus budget. Thus, policy of budget surplus is adopted to
remedy inflation. We will briefly discuss the fiscal policy to cure recession (boom) and to control
inflation (boom).

INCOME POLICY

There is a controversy regarding the effectiveness of monetary and fiscal policy between
monetarists and fiscalists. Keynesian model rejected the importance of money supply and treated
money as a veil and argued that fiscal policy is more effective in bringing stability especially
saving an economy from depression. On the other hand, the monetarists under Friedman insisted
that money alone matters and monetary policy is more effective in bringing stability in the
economy. When there is a financial or economic disaster, the Keynesians watch the employment
rate and the monetarists watch money supply for bringing stability. Yet, the post-Keynesians
question the validity of both approaches because fiscal policy or monetary policy alone cannot
bring stability in the economy. As such the post Keynesian solution to inflation is incomes policy
rather than monetary or fiscal policies. Hence, in addition to fiscal and monetary policies, we
have a number of other measures for bringing stability and for promoting full employment and
growth. Among other measures, Incomes policy is an important measure to stabilise the
economy at full employment level of output.

Meaning of Incomes Policy

The concept of “Incomes Policy” has gained currency in recent years as a means to fight
demand pull and cost push inflation. Income Policy attempts to halt the increasing prices by
preventing money wages from rising faster than productivity. Thus, the objective of income
policy is to prevent the factor incomes from rising at rates which are too fast to be compatible
with price stability. The central objective of this policy is to reconcile economic growth and price
stability. The price stability is to be ensured by restraining increases in wages and other incomes
from outstripping the growth of real national product. Incomes Policy seeks to concentrate on
curbing the private consumption expenditure in an effort to reduce the pressure of aggregate
demand on aggregate supplies. This concentration on restraining the private consumption
expenditure is due to the fact that private consumption expenditure accounts for about two thirds
or three fourths of the total aggregate demand. In other words, incomes policy implies deliberate
intervention by the authorities in the process of price formation for labour and products aimed at
preventing gross money incomes from rising excessively in relation to the growth of national
output in real terms.
Thus, Incomes policies are generally defined as action taken by the government with a
view to restraining wage increases and thus curbing inflation without increasing unemployment.
Given this definition which excludes self imposed restraint on the part of wage earners, incomes
policy can be seen as one element in governments overall economic policy. Thus, incomes policy
consisted of limiting wages and food prices. If real wage growth fails to keep pace with
productivity growth, there is a lasting and insurmountable constraint on the expansion of
domestic demand and employment creation. As wages have decoupled from productivity growth,
wage earners can no longer afford to purchase the growing output, and the resultant stagnating
domestic demand is causing further downward pressure on prices and wages, thus threatening to
bring about a deflationary spiral. Thus, incomes policies in economics mean economy wide-
wage and price controls, most commonly instituted as a response to inflation, and usually below
market level. Incomes policies vary from "voluntary" wage and price guidelines to mandatory
controls like price/wage freezes. One variant is "tax-based incomes policies" (TIPs), where a
government fee is imposed on those firms that raise prices and/or wages more than the controls
allow. Thus, incomes policy is used to maintain stability for averting deflation and to decrease
inflation in an economy.

Instruments of Incomes Policy

The important instruments of incomes policy are price controls and price freeze, wage
controls and wage freeze and food subsidies etc. When the price of a good is lowered artificially,
it creates less supply and more demand for the product, thereby creating shortages. Hence, these
instruments enable collective negotiation and monitoring of the wage and price agreements and
are used to stabilize the economy to avoid inflation and deflation in an economy.
However, incomes policy would have other effects. By arbitrarily
interfering
with price signals, they provide an additional bar to achieving economic efficiency, potentially
leading to shortages and declines in the quality of goods on the market, while requiring large
government bureaucracies for their enforcement. There are evidences that the wage and price
controls were effective in some countries during some periods.